Erik Hurst on the Risks of Re-Regulation

Erik Hurst is one of the brightest stars among the “new breed” of macroeconomists. He’s my go-to guy for trying to understand the complicated links between macroeconomics and how we actually live our lives.

One of the great joys of being an academic economist is enjoying a vigorous debate over a beer. While Erik and I don’t always agree, he has all the necessary skills — as both a debater and a drinker. Plus, he’s a fellow Dylan-ologist.

While we can’t share a beer on this blog, I thought it might be useful to bring him in on the conversation about the financial crisis.

The Dangers of Re-Regulation

By Erik Hurst

A Guest Post

My colleagues Doug Diamond and Anil Kashyap have provided a tremendously insightful overview of the current banking crisis; while another colleague, Luigi Zingales, has emphasized the very real deficiencies of the Paulson plan, highlighting how it will distort future risk-taking by investors and financial institutions.

My concern about the bailout comes from the sudden shift in political discourse towards re-regulating the financial industry. Popular belief holds that if the government had better regulated the mortgage industry, the current crisis could have been avoided. At some level, this must be right: if the government outlawed mortgages altogether, there would be no one to default on a mortgage. But we must not risk throwing out the baby with the bathwater.

Financial institutions are important because they transform our savings into investment capital for productive firms. Without this bridge from lender to borrower, it would be much harder for firms to expand, purchase new machines, or invest in developing workers or new ideas. We must ensure that the new regulatory framework ensures that financial markets continue to generate these enormous productive gains. My reading of the accumulated research (which I will describe in greater detail) is that the worst excesses of previous regulatory efforts throttled these productive gains. We must not repeat these mistakes.

A Little Bit of History

The usual story begins with the deregulation of U.S. banking that occurred in the late 1970’s and the early 1980’s. But it is worth going back to the regulations that Congress enacted subsequent to the Great Depression.

Congress was concerned with limiting speculation by commercial banks in order to prevent bank collapses. Consequently, Regulation Q was passed, capping the interest rate that banks were allowed to charge borrowers or pay depositors. The argument was made that this would limit speculation by commercial banks, as only speculators could afford to pay high interest rates on their bank deposits.

While it may be true that Regulation Q limited banking volatility, it only did so by limiting banking activity. But as Treasury Secretary Paulson and Fed Chairman Bernanke remind us, an active banking system transforms savings into capital, and so a reduction in banking activity likely led to less economic activity.

It is worth thinking through how these regulations stifled economic activity. Suppose that there are two types of banks: good banks and bad banks. Suppose the good banks are very good at identifying profitable investment projects, but the bad banks are less discerning. An efficient banking sector needs to funnel finance through the good banks.

How would these good banks attract the necessary capital? They need to be able to offer higher interest rates on deposits to attract the necessary funds. By capping interest rates, Congress artificially made it easier for the bad banks to compete with the good banks, leading many good projects to go unfunded.

Up through the early 1980’s, most U.S. states had restrictions in place that limited the extent to which their banks could establish branches, and they prevented local banks from being acquired by out-of-state banks. These branch banking laws severely limited banking competition; they prevented the good banks from growing while they allowed inefficient banks to prosper. Unfortunately, the good banks were prevented from driving the bad banks out of the market.

Relaxing these regulations led to massive gains in the efficiency of the U.S. banking system. These aren’t just abstract changes in efficiency; they have touched all of our lives.

Here’s a quick reading list of research showing that this deregulation yielded greater income growth; less volatile business cycles; better access to housing credit; offset racial discrimination in the labor market; and reduced crime.

The common theme of this research is that financial deregulation reduced interest rates and increased efficient lending and borrowing. In turn, people who were constrained from accessing a mortgage were now able to do so more easily, and firms found it easier to borrow, which led them to hire more workers.

With additional access to credit, consumers who lost their jobs during an economic downturn had to slow their spending rather than halt it; this yielded greater macroeconomic stability. And as competition allowed the good banks to prosper, providing productive firms with affordable credit, the economy grew and social externalities such as crime diminished.

The Current Environment

So that brings me back to the current situation. The past decade saw enormous financial innovation and the development of a liquid market to sell mortgage securities for unconventional mortgages (Fannie Mae and Freddie Mac had been securitizing “conventional” mortgages for a long time). Some of these new loans were issued to subprime borrowers: folks with little equity in their homes and lower credit scores.

Yet even as we recognize the costs of the subprime meltdown, we need to recognize the benefits of this innovation.

The homeownership rate in the U.S. increased by 3 percentage points over the past decade — a clear break from the two previous decades of stagnation. Around one-third of these households may ultimately default on their mortgages, but this also means that two-thirds of those who were previously excluded from mortgage markets now own a home.

Access to credit for this historically denied group is a clear benefit of financial innovation. Likewise, even if excessive lending landed us in this mess, the extra investment projects that were funded contributed heavily to economic growth over the past decade and supported the economy during the technology “bust.”

Where to Next?

Knowing what we know now, what is the optimal approach to regulating the subprime sector? Some argue that we should outlaw subprime lending completely. But do we really want to return to the world where the well-off have access to credit, but the historically denied (the poor, the young, African-Americans) can’t access the housing market or other credit markets? Is it really O.K. for only some households to use credit to help them ride out bad times, while others must just do without?

It’s a strange reversal of the usual ideologies, but those of us who care deeply about the poor must care deeply about cultivating a vibrant financial sector to service the subprime market. Otherwise, we truly risk two Americas: the credit-worthy who enjoy the benefits of the capitalist system and a highly developed financial system, and the less credit-worthy, who must live with a level of financial development that we suspect keeps so many third-world nations poor.

These are hard questions, to be sure, and I don’t know the answers. But we need to be careful to avoid the knee-jerk reaction of policy makers to “re-regulate,” which will stifle innovation and competition.

Any sensible proposal must give equal weight to both the costs and benefits of financial innovation. Unfortunately, politicians tend to emphasize only the cost side of the ledger in times of crisis. We must remember that, too often, financial regulation hurts the good banks more than the bad, and the needy borrowers more than the less needy.

Doing nothing, it terms of regulation, may risk a precipitous financial crisis. Doing the wrong thing — and regulating too much — would undoubtedly yield even larger, albeit less immediate, risks.


Where do conservative commentators and economists get off insulting us with such fear mongering as the old hack about baby and bath water. Just start with OUTLAWING and CRIMINALIZING "liar loans" as the double ended fraud that they are and go from there...the baby will be fine then, and after a good many other abuses are prohibited. If anything, the child will be awakened and consequently upset by miscreant whining.


Wall Street without regulation would be (is?) like the NFL without refs.


Thanks for your posts Erik and I hope you post again when you have some possible ideas for answers. I noticed a lot of news stating the SEC allowed many of these investment firms to raise their leveraging ratio from 12-to-1 to a high 30-to-1 in 2004. Wondering if this is worth re-regulating or is this waiving of regulation really helped the firms become more innovative somehow.


misterb - There has been plenty of innovation in the last decade. Plenty of the innovation was in finance. Packaging loans and spreading risk seemed like a really good idea, in fact it is a good idea, it frees capital for banks to lend to other businesses. Innovation in finance has occured in a number of other areas as well. Venture capital has exploded and expanded, and is responsible in part for getting to market many of the luxuries we enjoy today. The same can be said of microfinance, which has enabled the poor in many developing countries to grow their businesses and break the cycle of poverty.

Its not as if A students only go into capitalism. Quite the contrary, many go into biology, or technology fields. Many bright minds go into banking, and private equity because capitalism is the greatest catalyst of change we know of. Socialism assures growth will never occur.

Perhaps we'd be better served by getting C students out of politics then getting A students out of finance.



@Barry Nall (29)

I think you got it, but perhaps not violently enough. There is no such thing as a "good" bank or a "bad" bank in the capitalist sense. BMW makes better cars than Trabant, but money is money. There may be luckier banks and dishonest banks, but if we measure banks by profitability, the the ones with the riskiest loans are the "best" banks until their loans default.

Ultimately, if our society values pushing money around more than we value building cars (as evidenced by the compensation of these criminals) then our most effective people will push around money.

Regulation needs to take the profit out of banking to the extent that only C students get into capitalism, and the A students are innovating in science, arts, cuisine, architecture, construction, farming, carpentry, mechanics, medicine and comedy. If regulation ensured that anyone who met well defined criteria must be funded on a first come first served basis, then we take the "art" out of banking, and we put the art into innovation - where it belongs.



It seems that in this instance, as in many other global, local, personal, professional issues... we are noticing glaring human tendencies to swing back and forth over a course of history like a pendulum. Fear seems to be the driving factor- and it seems to me that the most educated people recognize the truth on both sides of the coin- and the need to bridge that gap.

But how then, in this instance- do we walk the razor thin line? The need for regulation is there, the need for no regulation is also there. Like many simple paradoxes, it's seems complicated when it needn't be. There is so much gray area to account for- how do large entities such as banks, governments, and countries, walk the line between two truths? In this case- regulation versus de-regulation?

And of course I have answers to this question- but realize no one probably cares. :-)


Greed does not self regulate. I really liked Ajit's post and agree with the tone of it. Yin/yang, fear/greed. On the housing for the poor... I'm not sure why it's good to push people who cannot repay a loan into a home. We don't throw people who can't swim into pools and act surprised when they drown.

Intelligent regulations are good. I have a problem with our congress coming up with INTELLIGENT regulations.

WAMU fails and some jack CEO that works for 17 days gets 20 million. This is GREED at work. It's incredibly destructive and unjust. There has to be a better way.

We should strive to align human nature with 'good' social causes. We want entrepreneurs to thrive. They should be able to take risks and thrive in a regulatory environment that does the least harm. Basically one that gets out of their way as much as possible. But we also want rules in place that prevent abuses.

I read a great article in Fortune on CEO pay and what to do about the excesses. It's tricky. Shareholders have not been able to, as a group, exert much influence on excessive pay and destructive golden parachutes, handshakes, or whatever. Those in power just seem to be able to stay a sliver ahead of the law. Or a sliver beyond detection.

This bailout makes it clear that Greed has to be controlled. The human animal cannot be trusted when they amass enough wealth and power to truly stick it to the rest of us.

But we have to be careful. Greed is simultaneously good and bad. It gets us off our couches in search of the great reward. The flip side of the same coin is its power of destruction.

The trick is encouraging ambition and risk taking and innovation with the same set of rules that prevent greed from taking down the whole system.


Anton Chigurh

In order for a super-duper financial system to make the economy to hum like a well-oiled machine it has to be stable. How was it that a problem in a relatively small part of the housing market (sub prime, I think you said 3% of the market) ballooned into being such a monster that it nearly brought the entire system to its knees? That it wiped out the likes of Bear, Lehman and Merrill and would have taken down many more if the Fed had not massively intervened? It is hard to limn the praises of an unfettered system when stuff like this happens.

David Thornley

Erik Hurst needs to make up his mind. Should good banks drive bad ones out of the market (which is what's happening right now), or should we bail out the bad ones? He can't have it both ways.

Also, this is not a new crisis. I was contracting at a major mortgage company a year and a half ago, and people were leaving the company as fast as they could find jobs elsewhere. The cube farm was looking pretty vacant when they finally got to letting me go.

Now, a year and a half later, we suddenly have to do something with seven hundred billion dollars of your and my money? Sounds awfully fishy to me.

Ajit, Sunnyvale, CA

(My earlier attempt at posting did not show up, no doubt due some technical error. I'm sure the blogger would not be censoring his critics :)

I'm glad that a significant fraction of the readers here are not buying Hurst's Kool-Aid.

Hurst's views represents what I call the Debt-Industry-Complex whose purpose is to invent financial instruments that help lower consumer loan thresholds. Once the consumers are up to the eyeballs in debt, and then the financial industry can package them in complex, non-transparent transactions to enrich themselves.

Simplistic? Perhaps, but it's mostly true. As posters #9 and #12 have mentioned, this discussion of regulation and non-regulation is a non-issue and a red herring. The current problem could have been avoided by a tweaking of the metrics that are within the scope of existing regulation. But that tweaking would reduce the amount of banking activity (limiting the extent of repackaging of loans) crimp the bonuses of the top echelons of Wall Street.

I have no problem with greed -- the capitalistic system that I subscribe to is a balance of greed and fear. I have a problem with being asked to suspend rationality and common sense, something that Mr. Hurst asks us to do repeatedly in his article.

Exactly why is it a virtue to "own" a house (rather, own a debt) when one has slim prospects of

paying the mortgage at market rates, let alone have the prospect ever paying the principal off?

My rule is not to trust someone who foists the specter of poverty and racism (or threatening the creation of two Americas) in defending something that does not jibe with common sense.

Hurst's comments are often patronizing. First, it appears to me that neither he nor his colleagues in the "dismal science", nor most of the Wall street bankers fully understand the detailed workings of this "highly developed financial system" he waxes about (one wonders about even the very basis of the risk analysis models that use Gaussian distributions without any actual data to support it).

Second, being from a "third world country", let me assure you that the lack of easy consumer credit is way down in the list of problems that prevent poverty reduction in many of these countries.

If we need to listen to anyone at this point for reinforcing our common sense and counter Hurst's approach of argument-by-ideological-assertions, it's got to be the likes of Warren Buffet.

Back to the issue of how to fix this mess without a sea-change in current practice. As a practising engineer, I'm all for small but very important tweaks that will keep the system going without anything revolutionary. Hurst, like other on the opposite side of the ideological spectrum, distract us from the true issues.

For an analogy, consider us in California at the mercy of an obtuse Legislature. Our budget problem could be solved in one stroke by changing the requirement to pass a budget from a super-majority to a simple majority. But no, the discussion among the Legislators and the pundits is for revolutionary change, like calling for a constitutional assembly to re-do the state Constitution!



This reminds me of a conflict solver my older brother used with me called "heads I win, tails you lose."

At some point you wise up and stop accepting those terms. I think that's the point that the general public is at right now.


As any economist knows, government intervention in markets _can_ be a good thing in markets with externalities.

The bailout is being justified by the claim that everyone, even people who had no part in getting or giving bad loans, will suffer if nothing is done. But this tells us that negative externalities exist in financial markets.

If negative externalities exist, unregulated financial markets end up providing too many loans, and the interest rate is too low. So the finding that "the common theme of this research is that financial deregulation reduced interest rates and increased efficient lending and borrowing" could actually imply that deregulation was a bad thing.

That being said, I whole-heartedly agree that any new regulation must be carefully thought out. Just any regulation is not necessarily good regulation.


There has to be a strong institution in order for regulation to work. Alas, regulation has been ad hoc as the Government allowed a system of trading in collateralized securities and bets (derivatives) to take place in a peer to peer forum, which of course gave incentives to the dealers and the creators of the securities to create more and more obscure entities. Before a regulatory regime can be imposed, the peer to peer system has to be broken by mandating that all exchanges must take place in a public exchange, and institution.

That, of course, is for starters. Then regulation should try to shoot down off the book entities. They've been fingered in every bust and fraud. They shouldn't exist.

An institutional locus would actually allow us to hone regulation to market reality. There is no problem, for instance, valuing equities - we can just look at the stock market and see what they are worth. Any economist who suggests continuing the regime of obscure values is actually subverting the sole reason that markets work, which is that they are supposed to be good at setting prices. No matter how you put it, that has failed in the financial system. The failure is due to the reticence of the government to "interfere" with an obviously dysfunctional peer to peer system.


nik /

GO Republicans!!

If you need ammo, here's a better plan ...

1. Central banks manage market liquidity and interest rates via open-market operations ... as they've been doing all along

2. Central banks act as lenders of last resort ... as they've been doing all along. They must, however, lend at market-equivalent (risk-compensating) rates, not politicized giveaway rates. If the (true, nonhyped) size of the crisis merits, these central banks should be allowed to lend at longer maturities (30 days up to 2 years) in order to provide some financial stability for borrowers. Collateral requirements must NOT be softened.

3. Congress must immediately cancel their winter hibernation. They can go on vacation once they've balanced the ENTIRE Federal budget, not a day before. If they can't do it before the election, they should be replaced by the voters. I don't care what it takes, we have to stop living on credit, and Washington is the best place to start.

4. Insolvent companies must go bankrupt. Period. Using the money available via points 1 and 2 above, new entrepreneurs will have a spectacular opportunity to take over businesses and run them better.

5. Insolvent households must go bankrupt. Period. They don't have to lose their jobs. They don't even have to lose their roofs (they can rent their McMansion from the new owner or they can negotiate a new lending arrangement via mandatory bankruptcy arbitration). But the Escalade must go. The Tahiti trip must go. The morning Starbucks must go. The 52-inch flat screen must go ... oh, and the digital cable. Groceries must come from Costco, not Whole Foods. Whatever it takes to get current expenses below current income so they can start paying down debt or building up savings. Period.

6. Incompetent politicians, bankers, and executives must be demoted. Just one notch. There's never been clearer vindication of the existence of the Peter Principle of promoting people until their job is beyond their capabilities.

7. The mark-to-market rule must go. Something better must be found in short order, but for now it's just causing unnecessary liquidity crunches and extreme volatility.

8. I'm open to persuasive arguements on mortgage insurance.

If I have to concede a point it is this: If the US government MUST take on assets, they should be placed in a new US SWF. For expediency, this SWF can initially be managed using the governance and by-laws of Temsek (a long-standing Singapore SWF). Everything must be transparent and done at market rates. The fund should be managed for profit by a set of (private, contracted) fund managers using the afore-mentioned Temsek goals on profitability and long-term stability. Period.

More at my blog:


Kerry G.

There is no attempt to answer this question, only to point out the obvious issue that there can be negative effects from poorly tailored regulation.

The question anyone but a free market fundamentalist would be addressing is how to regulate leverage in banking, ratings agencies, mortgage brokers, real property valuation professionals, short selling, government sponsored home mortgage lending, asset backed securities, derivatives, executive pay, etc. We have a major political party and many academics in economics departments who have operated as market fundamentalists over the last 30 years, only addressing regulation to discuss how it can go wrong. Their days are done; people see them for the fanatics they are. They will stumble around in denial while the rest of the country works to deal with the mess they've left us. It's time to address the difficult but necessary task of regulating the greed and conflicts of interest that will always be with us and that led to this conflagration while the free market fundamentalists fiddled.



Surely the author of this article did not mean to say regulation is about leaving the poor and the blacks out of the credit system. This is about credit responsibility, have we forgotten about responsibility? Credit guidelines are great, let’s start with a simple one. Do not borrow more than you can pay back – rich or poor, black or white. This is the reason for this mess – greed! People got too hungry for what they could not afford and those who showed restraint are going to pay for the lavishness of those who did not. Please do not tell me about social fairness; it has nothing to do with that. Address responsibility and we will be going in the right direction.

Paul K

The problem with regulation is the unintended consequences. The problem with de-regulation is the unintended consequences.

People forget that government regulation (including transparency) is an arms race. There are plenty of people who are trying to figure out how to skirt rules and visibility for gain - this is the nature of free markets. Some of it is patently illegal and we are often too slow to deal with it, but most of it is taking advantage of poorly written rules that allow tricks and deceptions (ie. loopholes). The companies and people that do find these loopholes tend to gain a lot of financial advantage, so they have plenty of incentive. The problem with deregulation is that it then tries to go on transparency, but those rules are far harder to write and far easier to skirt. In fact, in many cases, the companies do not try to skirt the rules, but overwhelm with too much data. Loan packages and CDSs often came with thousands of pages of information (not in a mineable form) and so becomes opaque because of the time it would take to find the danger hidden within. I think that is how we got here and how we would end up there again.

Solution: Find a way for people to make money on catching deception, hidden risk, and users of loopholes, and maybe we could solve some of this.


robert mccrary

There seems to be an assumption that with less regulation, it would be the good banks that would drive the bad banks out of business. Unfortunately, that is not always the case. A bank is nothing more than a business and any business reflects the attitudes and vision of its leaders. In man instances, this means the CEO, President and the Board of Directors. In today's corporate world, a Board of Directors is usually comprised of friends or acquaintances of the CEO and does their bidding. The relationship between the BOD and the CEO/President is almost incestuous. Much has been said about the excessive pay given to CEO's....but these are voted on and approved by the BOD. SO, what we often think of a good bank usually only means that it is a bank that has done good things under a specific CEO. When that CEO changes...and he changes the BOD to do his bidding, a good bank can quickly become a bad bank....draining off the cream to enrich the top officers who somehow feel entitled. There is no substitute for a rigid set of rules that will bind what any company can legally do. And, we must eliminate the term 'white collar crime' and think of wht these men and women do as criminal activity that puts them in the general prison population for longer periods of time. Sometimes, the only way to force someone 'bad' to think in 'good' ways is to make the punishment for getting caught so high that they become afraid to try to bend the system to meet their individual desires.


Joyce Leung

Yes, it important to strike a balance between too much regulation, which can choke off growth, incentives and creativity, and too little regulations which caused the financial turmoil which shocked the entire nation and the world in the past few weeks.

Regulation is not necessarily bad as long as it is addressing the real underlying problems in the current extreme financial crisis. It appears that bank executives had failed miserably in managing their risk exposure, and setting adequate capital requirements that could support that risk.

Sarah Phillips

What has made this country great is opportunity to fail and even make poor decisions. Regulating to deny the poor the opportunity to own a home is not the answer, even if they default!

Certainly we all know many who live way beyond what is afordable and prudent and that is NOT just the poor.